Monday, 15 December 2014

A
pickup in demand, a slowdown in shale oil growth, a cut from OPEC and a
recovery in the oil price are expected in 2015

Oil had an eventful
year in 2014. It rose all the way up to $115 in the first half of the year
before collapsing spectacularly in recent months—it now stands close to $60. This
post discusses four key questions which are likely to shape the oil market in
2015.

1. Will demand for
oil pick up?

Yes. Growth in the demand
for oil in 2014 was the weakest in five years—demand rose by only 0.6m barrels
per day (b/d), according to the International Energy Agency (IEA). But demand
growth is set to recover slightly in 2015 to 0.9m b/d on the expectation of higher
growth for the global economy. The International Monetary Fund forecasts an
increase in the growth rate of the global economy from 3.3% in 2014 to 3.8% in
2015. This is likely to have a positive impact on oil consumption. Lower oil
prices are also expected to contribute to the demand increase.

2. Will shale oil
production slow down?

Yes. The rise of shale
oil has been truly impressive. The US oil production is expected to increase by
1.4m b/d in 2014, mostly from shale. This means that the US has added the equivalent
of the total production capacity of a whole country like Libya in one year. However,
these gains are expected to slow down as lower oil prices make some shale projects
unprofitable given the high costs of extraction. Some shale firms have already announced
cuts in their investment spending for next year, while others are expected
to follow suit in January/February when they unveil their investment plans. As
a result, the US oil production growth is expected to slow down to 0.95m b/d in 2015.

3. Will OPEC cut
its production?

Yes. The latest OPEC
forecasts, published
a few days ago, suggest that a cut is probable. These forecasts indicate
that OPEC might need to cut 1.1-1.4m b/d from its crude oil production of 30m
b/d to balance the market and remove the excess supply (see Table 1).

OPEC will probably
wait until significant reductions in the investment spending of shale oil firms
have been announced before embarking on a cut of its own. This means that it is
unlikely to act before February but could potentially step in before its next
scheduled meeting on 5 June 2015. Therefore, the date of the OPEC cut could
be sometime around the second quarter of 2015.

4. Will oil prices
recover?

Yes—if we assume a
pickup in demand, a slowdown in shale growth and a cut from OPEC. Even then,
things might get worse before they get better. The market is likely to be oversupplied
in the first half of 2015 (see Table 2 where I modify the IEA’s projections using
my assumptions).

The implication is
that the average price of oil is expected to be around $60-70 in the first quarter
(Q1) of 2015, before reaching a low of $55-65 in Q2 as inventories build up. A
seasonal recovery in demand and a slowdown in supply growth in Q3 are projected
to lead to a drawdown of inventories, with the price recovering to around $65-75.
The momentum is expected to continue into Q4 when the price is forecast to settle
near
its equilibrium levelof
$75-90. Overall, the oil price is expected to average $69 in
2015.

Tuesday, 25 November 2014

If
the new consensus is right, the era of a triple-digit oil price is over

Oil price has
fallen to around $80 per barrel from its peak of $115 in mid-June. While the
new price is not particularly low by long historical standards, it does seem
low in comparison with the recent past given that it had stayed above $100 for
most of the three and a half years prior to the fall. So is the recent sharp
fall a result of temporary factors or a reflection of deeper fundamental forces
in the oil market?

A new consensus has
emerged arguing that a below $100 price is the new norm. The view suggests that changes
in the landscape of the global oil market—particularly on the supply side—are
leading to a lower equilibrium price, estimated to be in the range of $80-90
per barrel. This view is based on three propositions about the market over the
next few years.

1. The US oil
production will continue to grow, mostly due to shale oil. The shale revolution
is reducing the US reliance on imported oil, creating oversupplies elsewhere. While
this process has started in the mid-2000s (see the chart), other factors were
at play keeping global oil price high (demand from China and other emerging
markets, supply disruptions in the Middle East and so on). With these factors receding,
the continuous growth of shale oil is expected to keep oil price lower than in
recent years.

2. Shale production
will still be profitable at the new equilibrium price range. Shale oil is
costlier to extract, but the process is becoming more efficient. While there is
a great
deal of uncertainty about the minimum price at which the extraction of
shale oil is profitable for producers, the new consensus suggests that it could
be around $80. This means that at the new equilibrium range of $80-90, shale
oil is expected to continue growing, although at a slower pace than in the last
few years. Only a sustainable drop of oil price below $80 would make some shale
investments not viable leading to production cuts.

3. There will be no
supply shocks (positive or negative) from the Middle East. The new consensus
assumes modest production growth in Iraq (0.2m b/d each year) and a
stabilisation of Libyan production at around 0.7m b/d. It also assumes no production
growth in Iran.

Given these
assumptions, the new consensus expects oil to trade mostly around its equilibrium
range of $80-90, with possible temporary deviations due to the occasional
build-up of inventories or exceptional weather conditions.

There are risks to this
view. On the downside, further decline in shale production costs or a lifting
of the sanctions on Iran could result in more global supply and a further
decline in price. On the upside, supply disruptions in Iraq or Libya could lead to a higher
price, as could an aggressive reaction by OPEC to the price fall.

OPEC is meeting on
27 November and observers
are evenly split about the likelihood of a production cut. But even if the
organisation surprised with a production cut, it is not clear if its action
would be enough to turn the tide caused by the shale revolution. If the new
consensus is right, the era of a triple-digit oil price is over.

Tuesday, 16 September 2014

A
series of revisions to production targets will result in lower oil output from Iraq than
originally planned.

On 4 September, Iraq reached
an agreement with BP and the Chinese oil company CNPC to lower the planned
production target for Rumaila, the country’s largest oil field. The agreement
is not a one-off—it is part of a series of revisions to the targets that had
been originally agreed on with international oil companies in 2009. The
revisions will lead to a sharp fall in Iraqi oil output relative to the
original unrealistic plans.

The BP/CNPC deal
does not come as a surprise. For months international oil companies have been
negotiating lower production targets for the fields they run. ExxonMobil agreed
with the Iraqi government on a lower production target for the West Qurna-1
field. Lukoil did the same for West Qurna-2. Likewise for Eni and CNPC, the
operators of Zubair and Halfaya, respectively. Only Shell is yet to agree with
the Iraqi government on a new output target for the Majnoon field. It is
lobbying for a reduction from 1.8 million barrels per day (mb/d) to only 1.o mb/d, but
the Iraqi government is holding out for 1.2 mb/d. (The table below provides a
summary of the original and revised production targets by field.)

Such broad
revisions to the original agreements indicate a flaw in the way the contracts
had been awarded. The process involved oil companies submitting bids
specifying: (1) production target (the peak level of output the company would
eventually produce from the field); and (2) remuneration for developing the
field and reaching the target. Iraq then chose the bids with the highest production targets (since they result in more revenue) and lowest fees (less cost). But as
pointed out by James Hamilton, these auctions
encouraged oil companies to exaggerate production targets in order to win the
contracts. Once awarded, they began negotiating lower targets to move from “propaganda
to the reality”.

What does the new
reality hold for Iraq? The path of future Iraqi oil production will be
significantly lower than originally planned. Instead of producing 11.0 mb/d
from the six fields listed in the table above by 2020, Iraq has to settle for
only 7.2 mb/d. And even this target looks overly optimistic. To achieve it,
Iraq has to be more stable and efficient in the next six years than it has been
in the last five.

The production
loss is even bigger if we include the fields of Qayara and Nejma, which were
projected to add 230 kb/d by 2020. Sonangol, the Angolan company which had won
the contract to develop them, pulled
out of the country in February due to deteriorating security situation. The fields
are now under the control
of the Islamic State of Iraq and al-Sham, and there is
little hope for production growth from either of them.

Finally, while
BP/CNPC were not alone in negotiating a revised production target, the agreement
unusually included raising their shares in Rumaila. BP’s share increased to 47.6%
and CNPC’s to 46.4%, while Iraq’s stake was reduced to 6%. Iraq had previously maintained
a 25% share in all oil fields, and it is not clear whether this reduction is
unique to the BP/CNPC agreement or if it also applies to the other revised
deals. Iraq might be moving from propaganda closer to reality, but transparency
is still in short supply.

Monday, 1 September 2014

The
conflict in Iraq is unlikely to materially reduce oil production but could lead
to a significant slowdown in its growth.

The International
Energy Agency has released the full text of its monthly Oil Market Report. The report
raises interesting points about the current state of Iraqi oil production, some
of which I discuss below.

Source: International Energy Agency

1. Iraqi oil production continues
unabated, despite the ongoing violence. Officially, Iraq's daily oil production
averaged 3.1 million barrels per day (mb/d) in July. Oil fields in Kirkuk
pumped 0.16 mb/d; the Kurdish Regional Government (KRG) produced 0.31 mb/d;
with the southern fields responsible for the remainder of production at around
2.65 mb/d.

2. By capturing Kirkuk,
the KRG has doubled the production capacity under its control to around 0.85
mb/d. However, logistical constraints and political/legal disputes with the
central government in Baghdad has kept production at half capacity.

3. Logistically, the KRG does not have
the infrastructure to refine or export additional oil production. Fighting
around Baiji has resulted in the closure of Iraq’s biggest refinery—with 0.3
mb/d capacity. Furthermore, the Kurdish private pipeline, which has been used
to transport independent Kurdish exports, can accommodate current Kurdish
exports but very little on top of that.

4. The dispute with Baghdad over
independent oil exports has made it difficult for the KRG to find international
buyers. Of the six KRG cargoes which have left the Turkish port of Ceyhan since
May, only one has managed to offload its contents—at the Israeli port of Ashkelon.
Another cargo is a subject of a legal dispute before a US
court between Baghdad and the Kurds.The rest are still in limbo.

5. The Islamic State of Iraq and
al-Sham (ISIS) has added Ain Zahla and Batma to its existing
portfolio of oil fields, which consists of Najma, Qayara, Himreen, Ajeel and
Balad. This means that ISIS controls 80 thousand barrels of daily oil
production in Iraq alone—equivalent to 2.6% of the total official Iraqi output
(including the KRG).

6. Oil production and smuggling has been reportedly providing
ISIS with $2 million a day. These reports are not backed by hard data but
they seem plausible if we assume that ISIS is producing at 50% of capacity (40
kb/d) and selling crude at half price ($50 per barrel). It also means that losing
the oil fields could deal a significant blow to ISIS by depriving it from a
valuable source of funding.

7. Southern oil accounts for 85% of Iraqi
production and all official exports. Southern production and export
facilities are quite distant from the conflict zones in the north and west of
the country, and have been immune from sabotage. In the short term, violence is
likely to have limited impact on Iraq’s ability to pump and export oil.

8. In the medium term, violence could have quite a negative impact on oil
production and exports. First, the general deterioration in the country’s security
situation could lead to a disruption in foreign investment and missing out on
ambitious production targets. Some companies, such as BP and ExxonMobil, have
already withdrawn
non-essential staff. Second, trade partnerships are likely to be
tested, with China and India—the largest importers of Iraqi oil—pre-emptively looking
for supply alternatives.

Monday, 11 August 2014

Inflation
in Egypt increases to 10.6% and is set to rise further as the full impact of
the cut in subsidies is realised.

July inflation
data for Egypt were published yesterday. These are the first figures on inflation
following the government’s decision to reduce
its energy subsidies early last month. The headline figure showed annual
inflation accelerating from 8.2% in June to 10.6% in July. Monthly inflation—where
the effect of subsidy reduction is more pronounced compared to the annual number—was
3.1%, the highest increase since January 2008. Looking at the drivers of this
figure, three things stand out.

First, the direct
impact of subsidy reduction on prices has been lower than expected. For
example, the “housing, water, electricity, gas and fuel” component of inflation
rose by only 3.0% in July, despite double-digit price hikes for several energy
products. Similarly, the “tobacco and related products” item rose by 14.1%,
less than expected given the government’s recent decision to increases
taxes on cigarettes and alcohol. (See this
for a list of cigarette prices before and after the tax increase.) If the inflation
figure for July has not fully captured the effect of energy subsidy reduction
and tobacco tax hike, then we should expect further increases in the prices of these
two components next month.

Second, the
second round effects of the tax/price hikes are yet to be fully realised. For
instance, “transport” costs rose by 11.2% in one month from June to July
reflecting the rise in fuel prices, while prices at “hotels, cafes and
restaurants” rose by 4.4%. Prices of these two components might rise further after
the full incorporation of higher energy prices, implying additional contribution
towards inflation from these two categories in the future.

Third, food price
inflation in Egypt accelerated to 2.7% despite recent declines in international
food prices. This rise could be only temporary due to the effect of Ramadan,
and we might see a moderation in this component going forward.

In this sense, Egypt
has been quite fortunate that the reduction of subsidies coincided with falling
international food prices. Things could have been a lot worse if energy price
increases were coupled with food price inflation similar to the one witnessed
in mid-2008 or 2010, especially with food accounting for 40% of the consumer
price index basket.

Overall, annual inflation
will probably increase further as the direct and indirect effects of energy and
tobacco price increases get fully incorporated, notwithstanding lower food
price inflation. This is unlikely to spur the Monetary Policy Committee (MPC)
of the Central Bank of Egypt into further action in its next meeting. Instead,
the MPC may choose to wait and see if its pre-emptive interest rate
hike last month would prove sufficient to curb inflation.

Wednesday, 23 July 2014

Egypt
cut energy subsidies and faces the unenviable prospect of depressed output and
high inflation.

On 5 July 2014, the
government of Egypt reduced
its subsidies to fuel and electricity leading to a price hike in these
products. The government has also announced its intention to remove subsidies
completely within the next three to five years.
This comes among a set of other measures aiming at reducing the large budget
deficit which is becoming harder to finance. While the motivation behind
reducing subsidies is understandable, its likely outcome is stagflation—a
period of stagnant economic activity and high inflation.

The impact on
activity is straightforward. Higher energy prices mean that people have less
of their income available to spend on other items. The resulting fall in demand
leads to lower output and higher unemployment.

The effect of
higher energy prices on inflation however is more multi-layered. First, fuel
and electricity are included in the basket of goods and services from which
inflation is calculated, so their higher prices directly result in higher
inflation. There is also a second round effect as higher energy prices imply a higher cost of production in transportation and industry, which is likely to be
transmitted into higher prices for final goods as producers try to maintain
their profit margins. This leads to a further rise in inflation.

There is, in
addition, a third round effect: If the higher rate of inflation is expected to
persist into the future, workers will demand a pay rise by an amount equal to
expected inflation to keep their real incomes from falling. Higher wages mean a higher cost of production which in turn leads to the higher prices initially
feared by workers as their expectations become self-fulfilling.

While the first
and second round effects on inflation are inevitable, the third one is not. If
people expect the price increase to be a one-off event, then it will not pass
through to higher wages and prices and inflation will quickly fall. But if they
do not expect inflation to reverse, then this will lead to wages and prices
chasing one another resulting in runaway inflation. Getting one outcome or the
other depends on people’s expectations about the future path of inflation and
how serious policymakers are about bringing it down.

Which brings us
to the recent move by the Central Bank of Egypt (CBE) to raise interest rates
on 17 July. The CBE is clear in its
statement that the upward revision to energy prices with its direct and
indirect impact on inflation was behind its decision. The CBE raised interest
rates in order to “anchor inflation expectations and hence limit a generalised
price increase, which is detrimental to the economy over the medium-term.”

Raising interest
rates should encourage saving and reduce consumption and investments, hence
contain inflation. But a by-product of that policy is an even more depressed
output and higher unemployment. This is a price the CBE seems willing to pay to
keep a lid on inflation. Whether the CBE’s action and tools would be enough to
achieve its aim is something to be seen and observed.

Friday, 11 July 2014

Iraqis
left physically unharmed by violence may still have an economic price to pay.

Iraq witnessed
its bloodiest month in June since the height of its civil war in the summer of
2007. Preliminary data show that almost 2,000 civilians have died as violence
gripped the country. The figure would rise significantly if casualties from the
Iraqi security forces were also included. Not only does increased violence
threaten the physical safety of Iraqis, it also adversely impacts the economic
well-being of those fortunate enough to survive unharmed.

Data on casualties
from violence in Iraq come from two main sources. The United Nations Assistance
Mission for Iraq (UNAMI) publishes statistics on civilian and security forces
casualties based on witness reports as well as evidence from civil leaders,
government officials, international organisation, media reports and the UNAMI
own network in Iraq. The
figures released by UNAMI show that 1,531 civilians and 886 members of the
Iraqi Security Forces were killed in June. These numbers exclude deaths in the
Anbar province, where the UNAMI estimates further 244 civilian deaths. The
figures make June comfortably the bloodiest month since UNAMI started publishing
its statistics in January 2008.

The second source
is Iraq Body Count, a project to
record civilian casualties in Iraq since 2003 based mainly on verifiable media
reports. Its preliminary estimate for civilian casualties in June stands at
1,934—the highest number since August 2007, or the heydays of the civil war.
The data also show that 2014 is on track to become the most violent year
outside 2005-7.

Unsurprisingly, increased
level of violence tends to take its toll on economic activity. In recent years,
higher levels of violence in Iraq were associated with lower economic growth. As
the chart below displays, 2007 was the second most violent year and also the
year which witnessed the slowest growth rate. In contrast, the relatively peaceful
years of 2009-12 saw some of the highest levels of growth. Only 2006 stands out as
an outlier with both high levels of violence and a fast-growing economy.

What does that
imply about growth in 2014? If the levels of violence seen in the first half of
2014 were to continue into the second half of the year, 2014 would be the most
violent year outside the 2005-7 period. Should the impact of violence on the
economy be similar to the one witnessed in recent years, then we should expect real GDP growth of 4.4%.

Alternatively, a
more tragic scenario in which the elevated levels of violence in June continued
for the rest of the year would result in 18.5 thousand civilian deaths, making
2014 the third most violent year after 2006-7, the peak of the civil war. Under
this scenario, real GDP would grow by a mere 3.1%. Given that population is also
expected to grow by 3.1%, this would imply stagnant economic conditions for the
average Iraqi.

So what are the
economic costs of increased violence? The International Monetary Fund had
recently forecast real GDP growth of 5.9% in 2014, the recent rise in violence
would probably shave off 1.5-2.8% from this year’s real GDP—a significant cost
for a country still lagging behind in terms of goods and services provided.

It means that
Iraqis who were fortunate enough not to lose their lives or get injured during
the recent violence may still have an economic price to pay.

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About Me (Ziad Daoud)

I am an economist currently based in the Middle East. I have previously worked for an asset management firm and, before that, I did a PhD at the London School of Economics. The views in this blog are solely my own.